Quantitative Easing (QE) is a hot issue. But even though the term is used frequently by journalists, analysts and investors, most people are only repeating what they heard someone else say.

Let's see if we can shed some light on QE: the challenges the Fed is facing, the actions it's likely to take, and what an investor should do to prepare.

The upcoming announcement from the Federal Reserve will be one of the most important in recent months. The question is what you should do to be ready when the news is announced.

Some Basics

Quantitative easing is a strategy employed by a central bank like the Federal Reserve to add to the quantity of money in circulation. The premise (which is largely theoretical and untested) is that if money supply is increased faster than the growth rate of Gross Domestic Product (GDP), the economy will grow.

To understand the rationale behind the strategy, it helps to look at the basic relationship among GDP, money supply and the velocity of money.

In general, GDP equals money in circulation (M) times the velocity of the money through the economy (V):

GDP = M * V

Velocity is the speed at which money passes through the hands of one person or company to another. When money is spent quickly, it encourages growth in GDP. When money is saved and not spent, the GDP of the country slows.Today, one of the problems the United States faces is people and companies are saving their money and paying down debt instead of spending it. When people spend less and save more, the velocity of money falls and drags down economic growth.

Through quantitative easing, the Federal Reserve will try to counteract falling velocity by increasing the money supply. It has two primary tools with which to do it.

The first way the Fed manages money supply is via the federal funds rate. Banks with excess reserves can lend money to other banks that need additional reserves before closing their books for the day. The federal funds rate is the interest rate the banks charge each other for these overnight transactions.

The Federal Reserve sets the federal funds rate. As one of the most important interest rates in the world, it is widely quoted in the press.

The current fed funds rate is between 0% and 0.25%. Essentially banks can 'borrow' at a very low rate of 0 – 0.25%, making their cost of funds very low. Theoretically, this should encourage banks to lend funds to individuals and businesses at higher rates -- if they can borrow at 0% and lend to someone else at more than 0%, they make money.

The second tool the Fed uses is the permanent open market operation (POMO). The Fed uses POMOs to buy or sell securities that banks generally own -- mortgages, Treasury bonds, and corporate bonds. When the Federal Reserve buys securities, they trade the security for cash and increase the money supply. When they sell securities back to banks, they decrease the money supply.

In the past, the Federal Reserve has not resorted to this approach to manage the supply of money in the economy. But starting in 2008, it started buying large amounts of mortgage-backed securities (MBS) and Treasuries in order to add more money to the economy and help stabilize the banks.

Where We Are Today

Since the Federal Reserve has lowered the fed funds rate to 0 – 0.25%, banks have access to cheap money. The Fed was hoping that access to cheap money would encourage the banks to lend to their customers at reasonable rates. But it hasn't been that easy. The Fed has run into two problems.

First, many companies and individuals are afraid to borrow. They lack confidence in the economy. They prefer to save their cash and pay down existing debt. This phenomenon is reflected in the rising savings rate and the falling level of consumer and corporate loans. Not only has money supply not increased, but increased saving has slowed the velocity of money through the economy.

Second, banks are afraid to lend because they're afraid they won't get it back. Should the company or individual run into financial difficulty, the bank may be stuck with a loan loss. So instead of investing in loans, the banks are turning back around and buying high-quality securities like long-term Treasury bonds. Today, a 10-year Treasury is paying a yield of around 2.5%. With a cost of funds of 0.25%, this gives the bank an interest rate spread of 2.25% -- a very nice profit with almost no risk.

All of this means the Federal Reserve's attempt to stimulate the economy with low short term rates is not achieving its desired goal. The economy remains in slow growth mode.

And relatively high long-term Treasury yields (when compared to 0% short-term yields) have perversely created an incentive for banks to stop making loans except to the U.S. Treasury.

How Will Quantitative Easing Help?

The Federal Reserve recognizes that banks are using very cheap short-term money to purchase longer-term securities and pocketing the difference in interest income. So the Federal Reserve has decided it wants to drive down longer term rates and remove the incentive to buy Treasuries.

If the Federal Reserve buys enough 2-year, 3-year, 5-year and 10-year Treasuries, they force an increase in their prices. And bond prices are inversely related to bond yields: when prices go up, yields go down. A lower yield means banks cannot make as much money using the overnight money at 0 – 0.25% and buying long-term Treasury bonds, since the yield on those bonds will be pushed lower and lower.

The hope is the banks will then be encouraged to lend more, thereby stimulating the economy.

The Bottom Line

Most people expect the Federal Reserve to announce they will add another $1 trillion in new money to the economy by buying Treasuries. I don't think the Fed will go that far that soon. Announcing a large number commits the Fed to buying that many Treasuries and it doesn't give it the flexibility it needs to adjust the program as its effects ripple through the economy.

Rather, I believe the Fed will announce it stands ready to purchase 2, 3, 5 and 10-year securities in blocks of about $100 billion a month. The exact makeup will depend on the Fed's view of where it can get the biggest benefit for the money spent.

By carrying out the quantitative easing over a series of months, the Federal Reserve allows itself some flexibility to adjust purchases based on updated forecasts of the economy. It also allows the Fed to communicate its intentions over time, cutting down on the number of surprises inflicted on the fragile economy.

If the Federal Reserve buys $100 billion of intermediate-term Treasuries each month, it will place downward pressure on the interest rates of the Treasuries they purchase. But because the Fed has already telegraphed its intentions to the market, rates have fallen significantly in anticipation of the official quantitative easing announcement. Therefore, we are likely to see a brief move up in longer-term rates as bond traders close out their profitable positions.

After the initial shake out in the stock and bond markets, it's certain that economist will continually monitor the economy to gauge QE's effectiveness. If the program is encouraging more lending, the economy should start to grow faster. But if lending does not pick up, it is telling us borrowers and/or lenders lack confidence in the future and are unwilling to compromise their balance sheets. If this happens, the economy will remain in slow growth mode.

Fed Chairman Ben Bernanke is sure to make regular announcements on the state of the program. If he indicates they will buy more Treasuries in the future, it means the economy is not responding as well as he hoped, and he wants to add more money to the system. If he suggests the Fed will reduce purchases, it indicates his belief that quantitative easing is working and the economy is improving.

As far as trading, the short-term downside vastly outweighs the upside, if only because of uncertainty. If you are a short-term trader, you might want to move to cash to avoid the inevitable volatility that will ensue, as this is a sell on the news event.

If you are a longer-term investor, be sure to add some downside protection to your portfolio. You may also want to own some longer-term Treasuries, since the whole point of QE is to drive up the price of those specific securities. Don't be prepared to hold them forever, though. At some point (hopefully), the economy will grow again and bond prices will come back down.

This round of quantitative easing will be studied for years. We are in uncharted territory and the risks should not be underestimated. Capital preservation is important to success. Take steps to reduce your risk until we have a better idea of the longer term effects of this next round of QE.

P.S. Many investors are wondering how QE will affect the stock market. Many investors are also skeptical that we'll ever see benefits from the latest round of QE. If you want to hear their side of the argument, click here to read 9 Reasons Quantitative Easing Is Bad for the U.S. Economy.